Sunday, May 4, 2014

Imagine if the Price of Haircuts was Determined by Supply and Demand

A simple thought experiment shows how far the real world diverges from marginal pricing theory.

Imagine if barbers or hairdressers really determined the price of their service by supply and demand dynamics and in an auction-like market.

Imagine you went to get a haircut in such a world. You enter the store. If you were the only customer in the store, then you and the barber would engage in a mutual haggling process by which you negotiate a price for the haircut: you would give a lower price and the barber his higher price, and the haggling would continue until a price would emerge on which you could both agree.

Now imagine you went to get a haircut and there was a crowd of people in the store. At this point, the barber would auction off the next haircut or sequence of haircuts, and you would competitively bid against other clients. In the latter case, when the bidding was complete, all who wanted a haircut would have bid successfully for one, and all those who did not like the price offered would have left. The market – at least in a minor sense in the particular store – would have cleared, and supply offered at the relevant time period would equal demand.

It is likely that the price of haircuts would really fluctuate considerably in relation to demand and supply in such a world.

Simple reflection on how you really pay for haircuts reveals that this scenario is irrelevant for how the price of haircuts is normally set in the real world.

In reality, you enter a store and the prices for services are usually given in a list. The price is fixed and most probably based on the store’s total average costs plus a profit mark-up, and probably with reference to competitors’ prices too (and the internet is filled with sites advising small business-people like hairdressers how to calculate such prices just like this one). The price, then, is an inflexible cost-based, mark-up or administered price.

It is unlikely you can just haggle over the price. Instead of attempting to clear markets by price adjustments, barbers leave their prices unchanged and simply serve clients in the order in which they arrive: costumers simply wait their turn, as they read magazines or whatever (e.g., the last time I went for a haircut I read a National Geographic and the wait didn’t really bother me!).

In this sense, excess demand happens all the time in the hairdressing business, but although some people may grumble at having to wait their turn, nobody sees it as some disastrous economic “problem” where fixed prices lead to economic inefficiency and shortages. And who would want to live in a world in which you could never be sure what the price of a haircut would be every time you wanted to get one? By contrast, the real world tends to fix prices and to reduce uncertainty – and people prefer this world.

If a barber sees that he has long lines of costumers over a period of time and expects that this demand is going to last, he will hire more help: in essence, he will ramp up production and either (1) adjust his mark-up price to cover the new labour costs, or (2) might actually leave prices unchanged, if he already has a sufficient profit margin.

We live in a world where, in market after market, conventional supply and demand dynamics and auction-like markets are generally irrelevant to price setting.

What explains how we set prices in many markets is tradition, economic and social convention, and institutional development, not tidy supply and demand curves.

Yes, indeed. The queuing in the barber (or in the dentist or even in the shop to pay for goods) should be seen in terms of supply and demand arguments as a shortage or rationing condition.

If the barber responded to supply and demand he would raise the price until all but one customer left. Obviously that would be absurd.

I don't think that there is even a good case to make that barbers compete with one another. I live in a wealthy area of London. If I go to the local village a haircut costs about £20. If I go down to the poorer area near the underground station I can get one for £8. I don't think that the £12 difference is accounted for by quality at all.

You are plainly inferring that since no barber follows a curve the market in barbering does not. Composition. My local gas station posts prices. If there is a queue the price dies not rise while I sit there, if the plaza is empty the price does not tick ever downward. Yet supply and demand curves are a good model for gas prices in the whole market. As MF would doubtless say, it is an empirical question. You need to look at the behavior of the market. :)

"Philip PilkingtonMay 4, 2014 at 8:09 AMIn this case the firms do have to behave in the way that the curves describe otherwise the curves are meaningless."Perhaps. You have to show it though. I do not deny you can, I only assert you need to.

Your comment is an acknowledgement that LK did commit the fallacy of composition.

We are not going to turn into Murphy's here and construe questioning logic as making a substantive claim are we?

(1) I am not saying that supply and demand for hairdressing services do not exist!: of course there is a market in this sense.

(2) if a barber did a real world experiment and lowered his prices from a high price and constructed a graph with discrete points on it showing how quantity demanded each month was associated with a given price, then, yes, you may very well find it looks like curve (or you might not: it is indeed an empirical question).

(3) the point above is about price setting: the price of hairdressing services is usually a mark-up price and relatively inflexible.

The way people set prices here -- as in other markets -- is conventional and deeply ingrained: we probably don't think twice about the fact it is not how price would be set by strict supply and demand dynamics.The other point I made above is: can you find any people who think that waiting your turn for a haircut is some disastrous failure of production and an economic shortage that needs to be rectified by auctioning hair cuts?

Although in point (2) I stress that in any real world experiment obviously there might be factors other than price causing demand changes too, since in the real world you can't possibly hold everything apart from price equal (as in ceteris paribus).

LK,Of course prices are sticky and few are directly set by auctions. That does not mean SD curves cannot apply. If I were wicked I'd call that an Austrian argument! (It is.) it does have implications on time scales of course, which will vary by circumstance.

"My local gas station posts prices. If there is a queue the price dies not rise while I sit there, if the plaza is empty the price does not tick ever downward. Yet supply and demand curves are a good model for gas prices in the whole market."

Doesn't mark-up and marginal cost pricing achieve the same result for profit maximizing firms? I did some calculations with a simple example for a monopoly, using P = AC(Q)*(1+M), and got the same result. This, of course, assumes that firms have all the required information or can obtain it costlessly (which they don't and can't).

You are also criticizing models outside their scope of analysis. For instance, you say:

"And who would want to live in a world in which you could never be sure what the price of a haircut would be every time you wanted to get one?"

Have in mind that the model you're criticizing here assumes full information, so consumers would never be unsure about prices. Yes, this assumption is completely unrealistic and this model is as limited as its assumptions are implausible. However, that's a different issue. If you start assuming, for example, that changing prices implies costs both for firms and consumers, you'll get completely different results.